Non-GAAP Measures
Why Companies Use Non-GAAP Measures
Management argues that GAAP numbers can obscure underlying operating performance. A tech company that makes a large acquisition, for example, might carry years of intangible amortization that makes GAAP earnings look lower than its actual cash-generating ability. By presenting an adjusted figure, management aims to help investors see through the accounting noise to the core business.
The counterargument is straightforward: every adjustment makes the company look better. Nobody adds back items that inflate earnings. This asymmetry is why investors need to evaluate each adjustment on its merits rather than accepting the company’s framing.
Most Common Non-GAAP Metrics
| Non-GAAP Metric | Starting GAAP Figure | Common Adjustments |
|---|---|---|
| Adjusted EBITDA | Net Income | Add back interest, taxes, D&A, SBC, restructuring |
| Adjusted EPS | GAAP EPS | Exclude amortization, one-time charges, tax adjustments |
| Adjusted Operating Income | GAAP Operating Income | Exclude restructuring, acquisition costs, SBC |
| Adjusted Free Cash Flow | GAAP OCF minus CapEx | Exclude restructuring payments, litigation settlements |
| Funds From Operations (FFO) | Net Income | Add back depreciation of real estate (used by REITs) |
SEC Regulation G Requirements
After widespread abuse during the dot-com era, the SEC tightened rules around non-GAAP reporting. Under Regulation G and Item 10(e) of Regulation S-K, companies must: present the most directly comparable GAAP measure with equal or greater prominence, provide a quantitative reconciliation between the non-GAAP and GAAP figures, explain why management believes the non-GAAP measure is useful to investors, and not describe any non-GAAP measure as “recurring” if the excluded item has occurred in the past two years or is likely to recur.
The SEC has also cracked down on companies that use individually tailored accounting principles (ITAPs) — metrics so customized they essentially create their own accounting framework.
How to Evaluate Non-GAAP Measures
Start with the reconciliation table. For each excluded item, ask three questions: Does this cost actually recur? (If restructuring charges appear every year, they’re an operating cost.) Is the exclusion symmetric? (Does the company also exclude one-time gains?) How large is the total adjustment relative to GAAP earnings?
Track the GAAP-to-non-GAAP spread over time. A widening gap suggests management is finding more items to exclude, which typically signals deteriorating earnings quality. Compare the company’s adjustments to peers in the same industry to identify outliers.
Non-GAAP Measures by Industry
Different sectors have different conventions. Tech companies almost universally exclude SBC and acquisition-related amortization. REITs report FFO because real estate depreciation under GAAP often exceeds actual value decline. Banks focus on tangible book value, excluding goodwill. Understanding industry norms helps you distinguish reasonable adjustments from aggressive ones.
Key Takeaways
- Non-GAAP measures adjust standard GAAP figures by excluding items deemed non-recurring or non-operational
- The SEC requires a reconciliation to the most comparable GAAP figure with equal or greater prominence
- Common adjustments include SBC, amortization, restructuring, and impairment charges
- A widening GAAP-to-non-GAAP spread over time is a red flag for declining earnings quality
- Build your own adjusted earnings rather than accepting management’s version at face value
Frequently Asked Questions
What are non-GAAP financial measures?
Non-GAAP financial measures are metrics that exclude or include amounts not in accordance with GAAP. Companies create them by adjusting standard GAAP figures to show what management considers underlying operating performance.
Are non-GAAP measures regulated by the SEC?
Yes. The SEC requires companies to provide a reconciliation to the nearest GAAP measure, present GAAP numbers with equal or greater prominence, and explain why the non-GAAP measure is useful.
What is the difference between non-GAAP and pro forma earnings?
The terms overlap significantly. Pro forma earnings is an older term that typically refers to adjusted earnings in earnings releases. Non-GAAP measures is the broader SEC regulatory category that covers any metric deviating from GAAP.
Why do tech companies exclude stock-based compensation?
Tech companies argue that SBC is non-cash and fluctuates with stock price, making period-to-period comparisons difficult. Critics counter that SBC is a real economic cost because it dilutes existing shareholders.
How can investors protect themselves from misleading non-GAAP measures?
Always read the reconciliation table, check if excluded items actually recur, compare the GAAP-to-non-GAAP spread over multiple years, benchmark against industry peers, and build your own adjusted figures.